Craig Basinger: "Halloween Is Scary"

For the S&P 500, this was only the second down month this year. International equities did worse, and the TSX managed to stay in the green. Currency moves also deserve an honourable mention. The US dollar was strong, likely due to softening rate cut expectations and the upcoming election. Meanwhile, the Canadian dollar was weak for a host of reasons, from weak oil prices, the likelihood of our very own election, softer economic data, and the list goes on. The good news is that the US market, which was down in October, was up in Canadian dollar terms.

Of course, the election is a big uncertainty, with only a few days left. And we all hope for a smooth election and a smooth transition of power. Given so many expect some sort of contested election, anything that even remotely resembles ‘smooth’ would likely give this market another reason to move higher. Who knows, though? The winner is uncertain, and it could be a sweep or not. Regardless of how the market reacts, best of luck calling this one.

Earnings matter, regardless of who sits in the White House. And this market is starting to react. The Q3 earnings season is about 70% complete, and as usual, companies are consistently beating consensus estimates. The issue has become guidance, resulting in analysts continuing to revise down earnings expectations for 2025. It is relatively broad-based, with the more economically cyclical sectors down a bit more.

We are not going to say 'volatility ahead' because we think everyone always says this, and it's market commentary filler. Instead, the recession risk is low, inflation is still cooling, and earnings are growing (albeit a bit slower than before for 2025), which makes for a pretty good backdrop. We have elevated geopolitical risks, a market that may have already priced in a lot of good news and the election. And even with a weak finish, should that transpire, it's been a really good year so far.

Time to Go Small?

The infamous and awesome S&P 500 is actually a subset of the S&P 1500. Sorted generally by the size of the constituent companies, there is an S&P 400 midcap index and an S&P 600 small-cap index. S&P 500 + S&P 400 + S&P 600 gets you to the S&P 1500. The S&P 600 small-cap index has done alright over the past couple of years, annualizing about 10%. However, given that the large-cap S&P 500 has appreciated by 24% (annualized) during the same period, it has really been challenging to tilt towards a small cap. The more popular Russell 2000 small-cap index has had a similar path to the S&P 600.

There has been an increased number of inbound questions on size, specifically if this is the time to move down the size spectrum among US equities. And there are some rather compelling and some not-so-compelling factors to consider:

1) Valuations (mildly compelling) – The S&P 600 is trading 16.4x forward estimated earnings for the next twelve months, compared to 21.7 for the larger cap S&P 500. That is a pretty high spread, and even more so given small-cap usually trades at a premium valuation. However, this isn’t new news. The valuation argument has favoured small cap for the past three years, yet small cap has continued to lag. Honestly, it feels like valuations have not been a good determinant of performance for the past few years… that will probably change someday.

We don’t put much stock in the relative valuation argument for another reason. Index valuations are calculated by taking the aggregate earnings of the members based on weight. Small caps typically have more companies with negative earnings, often because they are at an earlier stage in their growth path to maturity. At the moment, 13% of the S&P 600 index members are money losers compared to only 2% for the S&P 500. These money losers detract from the aggregate earnings for the index and are one of the main reasons small cap usually trades at a premium.

Complicating earnings a little more, today, there is a lower frequency of money losers for both the S&P 500 and S&P 600 small cap index, which is one of the reasons for the valuation spread. So, valuations support small-cap, but we wouldn’t put too much stock in this argument.

2) Earnings growth (compelling) – This does look more encouraging for going smaller on the market capitalization spectrum. In 2022, there was almost no performance difference between the large-cap S&P 500 and S&P 600 small-cap. Both sucked – down 17% or so as markets fell on inflation/recession/rate fears. 2023 and 2024 (so far), the large-cap has dramatically outperformed small-cap... and look, relative earnings growth really favoured large-cap. This earnings growth advantage is forecast to flip in 2025 & 2026.

Of course, one risk is those estimates don’t materialize. Nonetheless, the return of earnings growth for smaller companies is a positive factor favouring smaller caps going forward.

3) The Fed & tariffs (compelling) – The Fed has started to cut interest rates as inflation cools. This is good news. More so for smaller companies that are more sensitive to changes in financial conditions. While smaller companies don’t necessarily carry a higher amount of debt compared to their equity or assets, they just have less flexibility or options when financing or re-financing compared to larger companies. This makes them more sensitive to changing financial conditions. The Fed overnight rate does impact financial conditions, as do many other factors from spreads, equity markets, and generally the availability of credit. Financial conditions have been more favourable for the past year+, which clearly hasn’t translated into a lift for small caps… but is a positive.

Don’t know who will win the election or what trade policies will be enacted. We do know the world continues to move towards more protectionism, a multi-year trend that started with Trump and continued under Biden. A Trump win may kick off another round of tariffs. A Harris win may result in a more gradual move towards more protectionism. Clearly, nobody is talking about making trade more free these days. Small caps generate more domestic sales compared to large caps that contain many multinational companies. The result is more protectionism is favourable for small caps over large caps. It may still be negative, but on a relative basis, larger companies are more at risk.

4) Economic momentum (mixed) – Small caps are more sensitive to economic cycles and to accelerating or decelerating economic growth. More exposure to the domestic economy certainly contributes to this differentiation. As does the composition of small caps vs large caps. Small caps have a higher weighting to more cyclical sectors including Financials, Industrials, Energy and Materials. Large-caps have a higher exposure to defensives, including Health Care, Communication Services and Consumer Staples. Plus, large-cap has a bit more growth, mainly from Technology.

The US economy grew by 2.5% in 2023, with this year expected to finish off around 2.6%. Currently, expectations are for a deceleration into 2025 to 1.9%, which is not overly supportive. However, a good trend has gradually improved small business optimism. The National Federation of Independent Business has a monthly survey, and the overall optimism among respondents is very good, with the performance of small caps. Of course, we can’t say if folks will become more optimistic or less going forward, but the improving trend over the past few quarters has been encouraging. As is the economic data during the past couple of months. It has been consistently coming in better than expected. Perhaps those forecasts for 2025 GDP will be proven too conservative.

Add it all up, and we are still a bit mixed about going too far down the size spectrum. For our US equity exposure, we remain tilted a bit more equally within the S&P 500, complemented by some market cap exposure and the dividend factor. Overall, this reduces the concentration risk given the size of the mega caps, but we remain in larger companies.

Security Selection for Banks Really Matters

Canadian banks have long been a cornerstone of the country’s financial landscape, offering solid growth, stability and, of course, some healthy dividend yields. They’ve weathered storms, often looking much better than their global peers. That strength has been rewarded by investors, with the banks earning a place as the foundation of countless Canadian investment portfolios.

Usually, it does not really matter which banks you own. Sure, every year has its winners and losers, but they typically all move in the same general direction. Over the past ten years, the average weekly correlation is 0.75; this year, that average is down to 0.43. The performance divergence has been huge, with CIBC up nearly 80% over the past year and TD flat. The chart below helps put that 80% spread into perspective. Since the early 90s, it’s only been this wide twice.

The performance chart below shows that the divergence started to grow a year ago when news of TD’s money laundering problems came to light. Coupled with runaway performance by CIBC, National and TD and concerns over loan book quality for BMO and Bank of Nova Scotia’s longstanding LATAM concerns, 2024 has truly been a year of clear winners and losers.

Factors for the divergence - The divergence in performance among the Big Six Canadian banks is primarily attributed to their differing strategies for expansion into the international markets (US and LATAM) and regulatory issues. Each bank has adopted a unique approach to US expansion, leading to varied outcomes in terms of returns. On top of these different approaches, the regulatory bombshell that’s driven many of these divergences is the fine for TD. Besides the fine, the bigger issue is the non-monetary penalty restricting the bank's deposits in the US. This effectively kneecaps their retail growth plans. Other factors dictating the winners and losers have been loan growth and loan book quality concerns. It’s easy to explain the reasons for the massive performance gap, but it becomes more difficult to project these differences well into the future.

Looking ahead, it’s hard to imagine another year quite like this one. Of course, loan growth, capital market activity and moves in wealth management will dictate winners and losers, but starting points matter. Valuations play a critical role in shaping future returns as they are a fundamental starting point for any investment strategy.

Valuations - The Canadian bank index is trading at 11.6x forward PE basis, slightly above its long-term historical average of 11.2x. On an average basis, banks are trading at a very slight premium, but averages can hide a lot. The table below highlights the widespread within the group. TD has historically traded at a slight premium to the group average but is currently trading at a 19% discount, resulting in a difference of -21%. Conversely, National and CIBC both trade at a historical premium. Royal is the richest by far, trading at 13.3x BF earnings, a 15% premium to the group, but that’s only slightly above its historical premium. Falling rates generally help P/E multiples move higher all else being equal. Barring a recession or worse-than-expected economic slowdown in 2025, there is potential for bank valuations to improve.

One of the core concepts in investing is mean reversion. This principle suggests that extreme price movements tend to revert to their historical averages over time. When a stock or asset becomes significantly overvalued or undervalued, it's often expected to correct itself. In the context of Canadian banks, a bank like TD, which is currently trading at a significant discount to its historical valuation and peers, could be considered undervalued. This undervaluation is due to KNOWN factors and reflects growth concerns and market sentiment. Sentiment rarely stays at such an extreme for a sustained period. Reversion is normal, and history backs this up.

Winners and losers - In 1999, we saw a similar extreme divergence among Canadian banks. TD was the top performer that year, up 60% year-over-year, while National Bank lagged, down around 20%. However, TD gained only 8.9% over the following year, while other banks, including National, climbed over 30%. This pattern has been repeated multiple times. For instance, in 2001, BMO surged 80% but declined 6.2% the next year, significantly underperforming the group. More recently, in 2021, National Bank led the pack, up over 70% from the COVID lows, only to post a more modest 14% gain the following year, while the group average was 27.4%. History shows that today’s losers can quickly become tomorrow’s winners and vice versa.

Final thoughts - We remain slightly underweight in banks due to concerns about Canada’s economic outlook, yet we see value in adding TD as its valuation suggests the potential for a catch-up trade. We continue to own winners and recent losers within our dividend portfolio. Diversifying isn’t just about geographies or sectors. Even among a specific industry like the banks, applying a diversified approach involves investing in more expensive, higher growth-oriented banks and cheaper, undervalued banks that perhaps provide lower downside risk given depressed expectations.

Market Cycle

Things are alright. If you are wondering why this market has been so resilient to the yen carry trade blowup, election risk (hopefully that lasts), rising geopolitical tensions, or other scary developments… it's simply due to a healthy backdrop. Overall, our market cycle indicators are stable and within a healthy range.

The rate backdrop is more encouraging, given that rate cuts are the norm. While the yield curve inversion is still negative, it has become less inverted. The US economy picked up a bit, including manufacturing. Housing slipped a bit, but the overall rating was net positive. The weakness came on the global economy side, with copper dropping, emerging markets weakening, and Baltic freight prices dropping. Fundamentals weakened a bit, too, as negative earnings revisions for international equities slipped into the red.

Once again, it does look like the strong US economy remains the best part of the news. This can be seen as well in economic surprise indices, which show the US as strongly positive, Canada as strongly negative, and international as more mixed.

There have been no active changes to our allocations this month; it's just normal market drift. We are back up to a good amount of cash to provide some optionality should the markets freak out over elections or something else. Given a healthy market cycle, we would view weakness as something to deploy into (using different words to say ‘buy the dip’).

Final Thoughts

There are two months to go in 2024, and unless something really bad happens, we will have enjoyed back-to-back strong years. The performance-chasing urge is certainly alive and well, and the fear is remarkably muted. That can change quickly. Stay diversified and try to resist the Sirens’ performance-chasing songs.

Authors: Craig Basinger, Derek Benedet, Brett Gustafson

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Sources: Charts are sourced to Bloomberg L. P.

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